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Downturn or not, people will still want to spend their hard-earned. With less to spend though, who will draw the cash-strapped crowds? Dan Coatsworth follows the bargain hunters and

charts the trade-down effect

Tumbleweed is blowing down the high street. Shops, restaurants and pubs are boarding up their premises. Bailiffs are knocking at people’s doors to reclaim possessions to cover unpaid bills. The dole queue is down the street. Will consumers ever spend again?

This, of course, is a total exaggeration of what is happening the UK. The media has been guilty of playing on people’s worst fears and blowing uncertain economic conditions out of proportion. Yes, the retail and leisure sectors are seeing harder times, but the tills are still ringing among a lucky few.

Rather than write-off consumer spending completely, you should be considering whether now is a good time to seek opportunities in value-for-money companies.

The stock market has priced down shares in consumer-facing companies and rightly so, as earnings are under pressure. This has created opportunities for bargain hunting, as a certain few could be the beneficiaries of ‘trading down’. Businesses could find themselves picking up custom from consumers – or corporates – who want to find a cheaper place than their regular leisure or retail destination or provider.

People are creatures of habit. If they can no longer afford to go to their favourite restaurant or holiday location, a less expensive alternative is often considered. But it is not simply down to price. Being cheaper than the competition doesn’t always mean a sustainable proposition. Quality is often sacrificed in favour of quantity. Pile ‘em high, sell ‘em cheap. Such businesses are still reliant on high volumes to make acceptable profit margins, which is fine if average disposal income is also high – clearly not the case for everyone today.

In a market downturn, consumers are going to be more selective with their spending. Quality of product and service will be of paramount importance.

Reliable brands with affordable prices will almost certainly prevail over standard cut-price outlets, and these are the companies you should seek out in the current trading environment.

Consider how people will try and save money. Here’s a few ideas, by no means an exhaustive list.

Consumer crisis

This isn’t speculative thinking. It’s reality. Christmas trading figures from retail and leisure companies have confirmed that there is a marked change in consumer spending patterns in recent months. The downturn is being driven by a cocktail of negative factors both home and abroad. Credit is harder to obtain; energy bills are rising; the property market is weakening; and workers are worried about job security on recession fears.

The Financial Services Authority has warned that one million people could lose their home within 18 months as they struggle with spiralling debts. Leading economist Roger Bootle believes the UK economy could grow by 2% this year and 1.7% in 2009, which would be the lowest two-year growth since 1992.

The chart (right) comparing the FTSE 350 index with retail and leisure sectors, shows the effect of these negative factors (and external influences like a US recession) on the stock market.

The chart paints an ugly picture. For the brave, it is also a trading opportunity as the equity whitewash has left many of the stocks looking very cheap. Most leisure stocks already discount a moderate downturn scenario in the share price, according to ABN Amro, although it says there is still risk to market valuations if a severe economic downturn occurs.

Using a stock screening programme, we have crunched the numbers to find bargain shares whose earnings are growing fast. Using the criteria of minimum 3.5% dividend and Price to Earnings to Growth (PEG) ratio of under 0.75, the system produces a list of 18 shares in the leisure and retail sector.

Taking into account that we want to find companies who could pick up custom as people look for cheaper alternatives to their usual spending destination, the list throws up several names that immediately do not qualify.

These include Land of Leather (LAN) which recently issued a profit warning as like-for-like sales fell 21.8% in the 13 weeks to 27 January. Big ticket items like furniture tend to be the first victims in a retail downturn.

Shares in Homebase-owner Home Retail (HOME) have been depressed as the DIY market dries up. It could have an outside chance of survival if its Argos stores take business from specialist retailers but Homebase’s problems could cancel out any earnings gains.

William Hill (WMH) and Ladbrokes (LAD) appear on the list but aren’t really what we’re looking for. James Hollins, an analyst at Daniel Stewart, believes people will still gamble during hard times in the hope of winning money. Yet it is hard to say whether consumers will switch to gambling as a substitute for other leisure activities, so we ignore these two stocks.

Trading down

One name on the list that immediately fits the bill for a potential ‘trading down’ beneficiary is pub operator JD Wetherspoon (JDW). The company has successfully built a brand synonymous with value-for-money food and drinks with establishments that are family friendly and spacious.

Analysts are divided over its current prospects, with eight ‘buy’ ratings against seven ‘hold’ and two ‘sells’. Wetherspoon’s shares have underperformed the FTSE All-Share by 39% in the past six months and the stock has become a target for traders taking short positions.

In the 11 weeks to 13 January, like-for-like sales fell 3.2%. Fewer people bought premium lagers and spirits, instead opting for real ale, food and coffee.

Negative sentiment towards the leisure sector and the smoking ban added pressure to the shares, but we believe the sharp price fall could soon bottom out.

‘Wetherspoon will pick up trade from people seeking alternative value but it hasn’t happened yet,’ says Landsbanki analyst Kate Pettem. She believes the company’s recent drop in trade has been caused by its customer base visiting less. ‘It gets lots of business from lower income earners, but these are the ones who are feeling the pains of higher household bills. They are still going to Wetherspoon but just not so often.’

A change is in the wings. ‘If the consumer confidence downturn persists, you will start to see the middle tier customers trading down to places like Wetherspoon,’ adds Pettem. ‘In a sense, there is already a shift as pubs are taking market share from restaurants as people like the stodgy food they serve, and lower prices.’

James Dawson, analyst at stockbroker Charles Stanley, says Wetherspoon’s recent menu upgrade has been well received. He warns, however, that the company is not alone in seeing food sales growth eat away at bar takings.

Like-for-like food sales in pubs and restaurants is around four times stronger than overall trading, according to stockbroker Blue Oar’s analysis of recent trading updates among quoted companies.

‘ONS data is showing that real expenditure on eating out has been growing at a slower rate than total household expenditure since the end of 2005,’ says Blue Oar analyst Mark Brumby. ‘Therefore we conclude that much of the sales growth of late has been driven by investment rather than demand.’

Brumby reckons that operators who already have facilities geared to food and have a differentiated offering should be cushioned from the slowdown in the drinking out market.

Landsbanki notes that Wetherspoon is opening pubs in small towns and is the only listed operators seeking such expansion. ‘While market towns may be small, they can draw large numbers of shoppers and small business people during weekdays. The positive surprise is that sites in small communities have done strong trade on the weekend, attracting customers from six or seven miles away,’ says Pettem.

Director dealings can be a good sign that trading will stand up over the long term. Who better knows a business than its senior people? Wetherspoon chairman Tim Martin has made three significant share purchases since November, taking his stake in the company to just under 23.5%. This prompted market speculation that he would launch a management buyout.

Time for a take-away

Domino’s Pizza (DOM:AIM) fared well last summer when the wet weather drove consumers to take-aways rather than eating out. The positive sales momentum has continued with like-for-like sales up 17.6% for the six weeks to 30 December. It is most certainly a candidate to benefit from ‘trading down’.

The company says it has never seen a decline in like-for-like sales since setting up shop in the UK 22 years ago. ‘We had flat sales at the start of the 1990s when times were tough, but this was only from 45 stores and an advertising budget of only a couple of hundred thousand pounds,’ says Domino’s chief financial officer Lee Ginsberg.

This year, Domino’s has £18 million to spend on advertising, funded by taking 5% of sales from franchisees. ‘There is a definite correlation between advertising and seeing a spike in sales. The large advertising pot this year means we can afford bigger promotions to drive sales,’ says Ginsberg. ‘This will help us through any economic downturn.’

The company didn’t escape the wider leisure sector share price decline in late 2007. Yet it has been one of the few fighters, clawing back lost territory in recent weeks.

Dawson at Charles Stanley believes Domino’s full-year results publication on 19 February should show the business to be in a better light than its leisure peers.

Its business model is perfectly suited to picking up trade from restaurants or even pubs. It attracts an average order of £15, feeding just over two people – compared with the same price per head in the casual dining market. New outlets can be opened easily, as it only requires a small property to cook and take orders.

Other fast food chains have seen their sales rocket in recent months. McDonalds reported double-digit revenue and operating profit growth in Europe during Q4, 2007. Burger King said its Q2 worldwide like-for-like sales were up 4.5%.

Domino’s has a reputation for being one of the best quality fast food providers, in terms of ingredients and service. Online orders grew by 60.5% in 2007. The average website order is more in monetary terms than phone or collection as customers spend more time browsing the menu, says Ginsberg. The margins are also slightly higher online, as orders are fed directly into store cooking systems rather than the sales assistant having to input the details, leaving them free to take phone and collection orders.

Supermarket sweep

Supermarkets are a threat to Domino’s as it is even cheaper to buy a pizza and cook it at home. Changing lifestyle patterns have seen more people arrange their own entertainment. This includes using the internet to order groceries, which has helped Tesco (TSCO), Sainsbury (SBRY) and Waitrose to extend their reach beyond physical stores.

Tesco has taken market share in non-food items from traditional high street players. Currys-owner DSG International (DSGI) and Woolworths (WLW) are among the retailers losing out on custom for electrical items to Tesco and its supermarket peers, who are offering cheaper products that can be picked up alongside the weekly food shopping.

With Tesco reportedly planning to open department stores selling food, clothing, electricals, sports goods and DVDs, competing retailers should be worried. Even John Lewis, which has recently enjoyed strong trade, shouldn’t underestimate Tesco’s appeal with consumers. It may have ‘only’ increased UK like-for-like sales by 3.1% over Christmas, but the retail giant still has a few tricks up its sleeve. Market rumours suggest it may reinvest overseas profits in UK price cuts.

Supermarkets are causing strife with pub and club operators as drinkers opt for a cheaper night out at home with shop-bought alcohol. One fund manager summed it up well: ‘Your average person is now more likely to pick up some beer from the supermarket and drink at home with their friends while playing on their Nintendo Wii games console, than go for a big night out.’

Look at the list of retailers which had a bumper Christmas and you’ll spot Game Group (GMG) near the top of the list. It was inundated with punters wanting to buy Playstation 3, Xbox 360 and Wii games consoles. With demand still outstripping supply for the Wii – the most popular item – Game’s tills should keep ringing for months to come. Although these items cost several hundred pounds, they are an exception to the big ticket rule where items like TVs and sofas don’t sell in poor economic conditions. The shared leisure experience makes consoles an investment that could more than pay for itself in comparison with the cost of taking family or friends out over a space of months.

There is healthy competition in the clothing sector yet finding a trading down opportunity is not straightforward. Marks & Spencer (MKS) produced a disappointing trading update last month that included poor clothing sales. Pali International analyst Nick Bubb says the earnings weakness – 2.2% drop in like-for-like sales in the 13 weeks to 27 December – was more to do with cannabilising existing food stores by opening new outlets nearby.

Associated British Foods’ (ABF) Primark clothes chain is among the market leading low-price retailers. Bubb believes it is taking share from BHS. It has a mix of practical and fashion items. Privately owned Top Shop continues to battle Swedish chain H&M and both compete against Asos (ASC:AIM). This online operation continues to grow sales but in an economic downturn it could lose out to Primark for its cheaper range of clothes.

Primark certainly has the brand strength and value pricing to win trading down business but is not a suitable investment for our criteria. It only accounts for a third of Associated British Foods’ profit and the parent company is facing serious sugar price pressures which could restrain any share price growth.

The holiday conundrum

Cheaper doesn’t always mean a better value proposition, as investors in several quoted stocks have found out. Hitchens (HIT:AIM) saw its share price fall 10% to 13.5p last week when it warned that plans to become profitable would take longer than planned. It sells surplus clothes and electrical goods through retail outlets and Ebay but has struggled with stock availability and lower selling prices. Instore (INST), which runs the Poundstretcher stores, is keeping its head above with water with sales but the share price performance has been abysmal.

If consumers were forced to cut their spending, they would reduce expenditure on clothes, food and drink rather than holidays, according to new research from TUI Travel (TT.). It found that 55% of respondents would cut back on their main annual holiday last if they were forced to reduce outgoings.

The table overleaf throws up some interesting scenarios but is slightly biased. The 500 or so respondents were all customers of First Choice (which was merged with TUI last year) and were already engaging with the brand, thus you could argue that they already showed a preference towards holidays.

That said, recent trading statements from both TUI and Thomas Cook (TCG) show no sign of the holiday sector suffering from an economic downturn.

Thomas Cook has cut the number of its holidays to reduce the risks of having to sell at last-minute discounts. TUI has taken a similar move to reduce capacity. ‘With less to sell in 2008, we think this should stand [TUI] in good stead if consumer confidence weakens further,’ says JP Morgan analyst James Ainley.

TUI has already increased forthcoming summer UK bookings by 9% compared a year ago, against a 14% drop in capacity.

The good old package holiday could become fashionable again this year if the more ambitious travellers struggle to raise money for their bi-annual pilgrimage across India or Asia, for example.

It is still easy to book two weeks in the sun independently of a tour operator, so competition is still an issue. That said, if Thomas Cook and TUI are both revamping their businesses following their respective mergers with MyTravel and First Choice last year, then there could be a push on better service standards which helps to win custom.

TUI is Europe’s largest tour operator so there is exposure to other economies apart from the UK to consider. It is worth a punt on two levels – first from the trading down scenario and second from post-merger operational efficiencies and streamlining the business.

Numis analyst Richard Carter believes EasyJet (EZJ) could tap into the corporate market seeking cheaper options. With new job cuts in the financial sector being announced nearly every day, it could prompt businesses across industry to scale back their expenditure.

Carter says Easyjet could pick up corporate business but doesn’t believe any uplift in revenue will be enough to offset the negative impact of a weakening leisure market. He suggests Whitbread (WTB) might be a better option for trading down with its budget hotel business, Premier Inn, well placed to attract more corporate business.

Premier Inn accounts for around two thirds of Whitbread’s group profit. It will launch a TV advertising campaign in the spring to boost leisure occupancy but this could also attract business custom. ‘The last time Whitbread advertised its budget hotels on TV, occupancy reached a record 82%,’ says Carter.

Class will out

Consider the flipside. If people are more reserved about spending money, will they simply pick the best to ensure quality? British Airways (BAY) has reported stronger demand for premium-class traffic than economy. It is even launching a business-class-only service next year from London to New York.

Specialist travel operators say their business is booming. All Leisure (ALLG:AIM) runs cruises where there is an emphasis on learning about local cultures as well as entertainment. Its average customer is 55 years old, has paid off their mortgage and doesn’t have financial worries to deter leisure spending.

Bespoke kitchen maker Smallbone (SML:AIM) sells into the top end of the property market. Its share price has been fairly resilient against the stock market downturn in recent months. Full-year results due at the end of February could be worth investigation to see if demand is still strong for its premium products. Walker Greenbank (WGB:AIM) says strong sales of expensive wallpaper and fabrics will help it to beat analyst earnings forecasts for year to 31 January 2008.

High-end restaurants in London are still packed out every lunchtime and evening. Greene King’s (GNK) acquisition of Loch Fyne restaurants could be the saviour of the group. Pub trading has been patchy but like-for-like sales have risen by 2.3% at the up-market seafood chain since Greene King bought it last August.

Mid-tier restaurant group Carluccio’s (CARL:AIM) continues to do well. Unlike many of its peers, it is pressing ahead with expansion plans across the UK and into Ireland via a franchise deal. With a strong reputation for quality Italian food with a deli tagged alongside, it could have just been lucky to have found the right ingredients to ride through tougher climates.

Property agent King Sturge acts for casual dining group Gondola Holdings. Senior associate James Woodard says the company, which owns the Pizza Express, ASK and Zizzi chains, continues to search for new restaurant sites, adding: ‘The market has changed but there are still as many opportunities for those with a strong enough brand.’

However, when one of the world’s most famous luxury brands, jewellery retailer Tiffany, warns that profits will miss market expectation, it shows that you cannot predict where the market will turn to next.

‘Survival depends on your clientele,’ say Dawson at Charles Stanley. Unfortunately the industry is still scrabbling to spot the exact type of person who can still be relied upon to spend as there are still pockets of low, mid and high-end operators reporting solid trade.

Anyone brave enough to try and capitalise on the stock market weakness, trading down is a logical approach. We cannot emphasis enough that it is a high-risk strategy but if you have the confidence and non-essential funds, it could be a gamble worth taking.

3 Slump Beaters

BUY JD Wetherspoon (JDW) 341p

Market cap: £497 million

PE: 12.1

PEG: 0.7

Dividend yield: 3.5%

3-month relative strength: -27.6%

6-month relative strength: -36.6%

The share price fell 61% to 292.5p between April 2007 and January 2008 as the company felt the pressures of the England smoking ban, wet summer weather and now economic downturn. A small uplift in the share price has emerged in recent weeks as investors weigh up Wetherspoon’s potential to take custom from more up-market establishments. Pre-tax profit is forecast to grow 5.3% this year and 8.6% in 2009. The latter may reduce given scaled back expansion plans. Wetherspoon was one of the first to suffer from negative sentiment towards the pub sector because of its low-end customers. You could argue that this is now fully priced into its stock and there is less downside risk. Food price inflation is a concern but brand strength should stand it well in troubled times. We had Wetherspoon as a ‘hold’ last month and now upgrade to ‘buy’ upon reconsideration of its prospects.

BUY Tesco (TSCO) 416.75p

Market cap: £32,648 million

PE: 18.6

PEG: 1.8

Dividend yield: 2.3%

3-month relative strength: -1.6%

6-month relative strength: +12.1%

Like-for-like sales over Christmas weren’t as good as expected and the jury is still out on its US expansion. This is more than offset by solid gains in Asia and Europe. The online service continues to attract customers and catalogue sales have been good. Tesco has been widening its non-food product range, which should help to it take business from traditional high street retailers. Its food offering also caters to a broad audience as it has a value range to finest range.

BUY Domino’s Pizza (DOM:AIM) 190.5p

Market cap: £309 million

PE: 29.4

PEG: 1.1

Dividend yield: 1.6%

3-month relative strength: -8.3%

6-month relative strength: -22.2%

Amid last summer’s market crash, the leisure sector downturn and rising cost of raw materials to make its pizzas, Domino’s saw its share price halve to 150p between July and December 2007. A solid trading update in early January has put the business back on track. Like-for-like sales increased by 14.7% in 2007, with notable trading gains during the wet summer and over Christmas. Its focus on ‘superior service’ is paying off, giving customers fresh produce without making them wait too long for delivery. Domino’s franchise model is the envy of the leisure industry. It has dealt with higher operating costs by passing them on to the consumer without any complaint.